Image caption
Mr King said banks would need to rely on "much, much more equity" to finance risky investments

Bank of England Governor Mervyn King has attacked the 'absurd' level of risk taken on by banks in a speech.

He called the banks' reliance on short-term debt to meet funding needs in 2008 an "accident waiting to happen".

He said that, in future, banks must be forced to rely much more on equity to finance their risky activities.

His comments raise the prospect that big UK banks will be required to hold significantly more equity than new international rules require.

In order to do this, the banks might have to issue new shares, pay out less profits as dividends, or ration new lending more tightly.

Tighter rules

In September, the Basel international committee of bank regulators raised the minimum ratio of equity that banks must hold to absorb losses on loans and other risky investments from 2% to 7% of assets.

However, the committee said that even higher ratios were still to be agreed for the biggest banks whose failure would pose a risk to the financial system.

And individual regulators - such as the Bank of England - are free to set even higher standards if they choose.

Mr King says we need to look at highly radical reforms of the banking industry

The Swiss announced much higher capital ratios for their two biggest banks earlier this month.

'Achilles heel'

Mr King said that the new Basel minimum capital ratios were inadequate to address the problem of banks that are too big too fail, such as Barclays, HSBC and RBS.

Such banks, he said, enjoy an implicit guarantee, which gives them an incentive to take on excessive risks.

He also said that the coalition government's proposal for a bank levy - which is expected to raise £2.5bn a year - would be nowhere near enough to cover the losses of a future financial crisis.

"The balance sheets of too many banks were an accident waiting to happen," he said, referring to the 2008 financial crisis.

If only banks were playing in a casino, then we probably could calculate appropriate risk weightsMervyn King, Governor of the Bank of England

"For all the clever innovation in the financial system, its Achilles heel was, and remains, simply the extraordinary - indeed absurd - levels of leverage represented by a heavy reliance on short-term debt," said Mr King.

"The broad answer to the problem is likely to be remarkably simple. Banks should be financed much more heavily by equity rather than short-term debt. Much, much more equity. Much, much less short-term debt."

He claimed a future crisis could only be averted by requiring capital levels that would "be seen by the industry as wildly excessive most of the time".

He expressed scepticism about the idea that banks could calibrate their borrowings depending on the riskiness of their investments.

"If only banks were playing in a casino, then we probably could calculate appropriate risk weights," he said. "Unfortunately, the world is more complicated."